Thoughts and Commentary on Socially Responsible Investing

September 06, 2008

Due to the emergence of new commitments and the growth of old ones, I am making my final posts to this blog in August/September 2008. This is the second of two brief essays on the philosophical justification for social investing.

In my first note on this topic, I compared social investing to the Latvian Gambit, a popular but probably unsound chess opening. In this essay I'll draw another, more hopeful analogy.

I guess I should acknowledge that my motivation for elaborating on this theme is partly emotional. On the rare occasions when I've met genuinely influential people, or apparently skilled investors, their interest in social investing has been minimal. Sometimes their reaction verges on pity, or disappointment that I would waste a lot of time on this.

I hate that.

I should hasten to add that these people are almost never rude. They're not trying to be oppositional or patronizing. It's just that powerful and accomplished people generally think the world's a pretty tough place, and good intentions don't get you very far. Warren Buffet once told journalist Marc Gunther "I've seen a lot of not-very-good people succeed in business... I wish it were otherwise."

Well, let me propose another analogy. I do believe there is another way of looking at this, which casts social investors in a potentially more important - even critical - role.

In the early 1920s a group of chess players emerged who became known as The Hypermoderns. They played weird openings - things that had not been seen much before, and which appeared to the chess orthodoxy to be as unsound as the Latvian. They had their victories and defeats. None of them ever became champion (although some champions were deeply influenced by them), but many of the strange openings they played turned out to be pretty good. Some of those openings became standard issue for up-and-coming masters. Ultimately hypermodern openings played a significant role at the top level of play - from Anatoly Karpov's frequent use of the Queen's Indian Defense, to Bobby Fischer's surprise deployment of Alekhine's Defense in his match with Spassky.

The point is that the initial reception to an intellectual innovation tells you nothing about its ultimate validity. The greatest chess players in the world thought Alekhine's Defense was a bad idea when it was first played. A generation later, the greatest chess player in the world used it successfully in the most important match of his life.

This is the norm. In any field of intellectual endeavor, but especially in competitive ones, new ideas arise, are dismissed, are fought over, and ultimately, if they are valid, become a part of the orthodoxy.

This doesn't mean that social investors are right, but it does mean they should investigate and develop their theories. They can certainly expect opposition and indifference, and they will likely meet with these regardless of the validity of their claims. Bill James, the man largely responsible for the modern revolution in baseball analysis, once wrote something to the effect that "if I have to play Galileo...[someone else] has to play Pope." Which was probably true, but also hints at some of the psychological pitfalls faced by the innovator.

So, if the opinions of even brilliant theorists and practitioners are not a reliable guide as to the validity of social investing, what might be? I'll offer two answers - one empirical and one analytical.

First, from an empirical perspective, we have plenty of performance and market share data now. The social indexes and mutual funds have been closely studied for many years, and their performance has been competitive. And, as the Social Investment Forum'sTrends report shows, social investment products have taken share over the years. Any investment style can generate performance and win share over a brief time, but social investing has been operating and growing in influence since the 70s, in every imaginable market environment. To return to our earlier analogy, that seems to fit the experience of the Hypermoderns more than it does the Latvian.

But why should we expect our success to continue? What, apart from performance and market share numbers, can we look at when we assess the advisability of social investing?

My analytical answer is as follows: When you look at the history of any intellectual endeavor, it is striking how many big discoveries, at any moment up to the very recent past, had not yet been made. We are accustomed to thinking of ourselves as living in "modern times" and we think of our knowledge as pretty complete. But it ain't.

Just think of the advances in medical treatments over the past generation. Here is a picture from the 1968 movie Bullitt, which was partly filmed on location in a San Francisco hospital, with real doctors and nurses on the set. The directors were going for an 'authentic' look. Think of what's not there. No computers, no imaging technology, no ultrasound. I think it's fair to say 1968 was a year in modern times - and medicine was very advanced compared to what it had been 40 years earlier. But there was so much more to be learned.

I think of social investing in the same way. Whatever the experts say about efficient markets or the power of quantitative modeling, we simply must admit we don't yet understand financial markets very well. I am not just trying to score a debating point here. Our failure to appreciate the magnitude of our ignorance is a real threat to us.

There was a terrific article (sorry, it costs three bucks) about the Great Depression in The New York Review of Books last year.Those who think economists march in lockstep should have a look at the debates they have over the Great Depression. There are still many points of contention. Ben Bernanke made the role of financial intermediaries in the Depression a particular specialty in his academic career, which is probably really fortunate given his current role.

I occasionally ask the economists I meet if the Great Depression could happen today.No, they generally say, becausewe have learned so much. John Kenneth Galbraith, when asked about this following the 1987 Crash, pointed out that our safety nets are much better-developed.Milton Friedman and Anna Schwartz pointed out central banking mistakes that almost certainly made a bad situation worse during the Depression- an error Bernanke promised, at a conference honoring Friedman on his 90th birthday, not to repeat.

For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

The theme I take from all this is that, back in those days, we just didn't know. The elites were as confident before the Great Depression as they are today, the speculators were just as arrogant and aggressive.

So what don't we know about the equity market? Fama and French might argue that we know quite a lot about past patterns of equity returns (an excellent crash course is here). But as computing power becomes cheaper and backtesting software becomes more sophisticated, isn't it possible that the markets will arbitrage away most of these effects? Mightn't we move gradually from the world Fama and French observe toward one in which there are no exploitable statistical anomalies? Some academics think we've already gone there and beyond - with so many people trying to exploit the same effects, herding can occur, making the market less efficient, not more so.

(An aside on market efficiency: in my adult life the market has traded at 1x book value, in 1980, and 5.5x book value, in 2000. There's a good chart in this book. My economist friends tell me we have an efficient market, but I have my doubts.)

But let's say cheap computers and global Internet access do their work, and the market becomes very efficient with respect to quantitative variables. When that day comes, where do we look next? Well, everywhere the quants can't reach: governance, employee relations, sustainability...

And those happen to be the areas where social investors have been developing their craft these past 20 years. At our best, I think social investors can help markets identify and appropriately recognize good organizations and good management teams. Not everything we do maps to those tasks, and there is plenty of work to be done before we can claim to be adept at it. But that, I think, is the opportunity - social investment techniques may become more important in mainstream investment research.

And this is not really heretical. Jason Zweig notes in his updated edition of Graham's The Intelligent Investor that Graham wrote a great deal about governance and management quality in the early editions of the book. As time passed the section got shorter and shorter, because, Zweig speculates, Graham despaired of anyone actually paying attention to it.

Graham well understood that the shareholder is in a vulnerable position. When you buy a stock you commit your money to an enterprise managed by strangers. You must ultimately trust those people. But it is difficult for any layperson to assess whether those managers are honest and competent. It can even be difficult for well-connected monitors to determine this, as evidenced by recent developments at U.S. financial institutions.

I would not claim social investors have special insight in these areas today. Heck, many social investors owned Enron before it went down in flames. But if you think about where investment practice is going, and where we will have to look to earn returns in the future, I think we are on the right part of the playing field.

August 28, 2008

Due to the emergence of new commitments and the growth of old ones, I am making my final posts to this blog in August/September 2008. This is the first of two brief essays on the philosophical justification for social investing.

The news appears good for us practitioners – social assets rose 18% over the past two years, compared with just 3% for the market overall.With one dollar in nine now managed according to some social constraint (mostly tobacco, still) social investing seems to have made a place for itself in the investment world.

And, from Wall Street and most of the famous business schools, a collective yawn.Now Wall Street has other things on its mind this year.But even as client interest has increased, my professional and academic colleagues remain mostly disinterested. And, disturbingly, the most indifferent people are often the most accomplished theorists and practitioners.

I recently realized that I have seen this situation before, in a completely different context . I hope the comparison will shed light on the intellectual obstacles social investors must yet surmount.

In chess, there is an opening call the Latvian Gambit.It is a violent response by Black to the most common first move by White, an attempt to turn the game into a desperate and deadly struggle from the outset.

It’s easy to describe: On the first move White pushes the pawn in front of the King forward two spaces.Black does exactly the same thing.Then White brings out the Knight next to his King, so it attacks the Black pawn.

This is the defining moment – Black can bring out his Queen’s Knight to defend the pawn (the most common choice, leading down well-traveled roads).Or, Black can counter-attack, bringing out the King’s Knight (this is called Petrov’s Defense, and it is very playable - Kasparov has scored successes with it).Or, Black can try something sort of crazy.In the Latvian the player of the Black pieces leaves the King’s pawn undefended, and charges forward two spaces with the pawn in front of his King’s Bishop.This opens up attacking lines for the Black Queen and dares White to waste time capturing the loose pawn in front of the Black King.It also opens huge gaps in the Black position, guaranteeing that however exciting the game will be, it will not be a comfortable one for the Black king.

What happens next is anyone’s guess, but the game will usually be tactically complex, full of cut-and-thrust action, with sudden death a real possibility for both players.

The Latvian has a loyal following, or cult, if you like.There are entire leagues of correspondence players who essay the Latvian against one another.It is certainly not in the mainstream: critics deride it as a ‘coffee-house opening’.But when you think about it, that means that in coffee houses all around the world, there are Latvian loyalists – people whose greatest satisfaction of the day is to push that impudent pawn to f5 and smile across the board at the opponent, as if to say – ‘we’re in for it now!’

But there is a problem, and the more serious you are about chess, the more serious it becomes.The Latvian is entertaining, but it is also almost certainly wrong – a loser against best play.The English Grandmaster John Watson has denounced it.The great American chess educator, Jeremy Silman, says simply:it’s bad.The only grandmaster work I have seen on the opening – Tony Kosten’s The Latvian Gambit Lives! - seems to acknowledge in places that if White plays a certain way, well, Black will probably lose.Yes, you can try it against your neighbor, or at your chess club, or even against pretty fair local competition - even Silman says it offers "good practical chances against an unprepared opponent."But it simply is not seen at the highest-levels of play.

Is this where we are with social investing?It is popular, yes, and apparently growing more popular each year.There is no shortage of people who pay lip service to it. But most of the strongest academics and practitioners still ignore it.Some theoreticians are sympathetic, especially on the behavioral side.But most of those with a strong quantitative bent simply cannot see how social investors can avoid incurring uncompensated risk.Financial economists (people like Chris Geczy or Brad Barber, for example) will tell you that constraints matter, and that social investment portfolios may be too constrained to achieve optimal results.So, no matter how sympathetic they might personally be, they are going to have a very tough time believing social investors can earn consistently strong returns relative to the market.

For the most part, with the single exception of the late John Templeton, the best practitioners are also reluctant to go along.Soros and Buffett have strong social consciences, but no apparent interest in social investing. The strong practitioners I know say: We’re playing a competitive game here.It’s a zero sum game, and you only get paid if you win.So if you are playing to win – ‘chasing alpha’ as the expression goes - you had better focus on the things that matter for returns.

You might point out to them that some of the things social investors care about do seem to matter for returns.You could show a few studies (Gunster, Barber, Edmans) that find positive performance effects.But you’ll just get a wave of the hand.Maybe, and maybe not, the practitioner says.You might be bringing me alpha.But you’re definitely reducing my options, and you’re definitely increasing my tracking error.In their world, and on their time horizon (usually less than a year), ESG doesn’t matter enough to change their behavior.

So, does that define the role of social investing?Social investors, if this analogy holds, are the club players of the investment world, trying hard and expending a lot of energy, and perhaps deriving some psychic benefits, but ultimately having no impact on the highest level of play.

I have long been an advocate of social investing because I believe values matter, and if values matter anywhere, they must be exceptionally important in business, where welath is created and most of us spend the majority of our waking lives.

But this analogy bothers me.The shoe fits better than I would like.Perhaps social investors can take comfort in the endorsement of a John Templeton or the sustained interest of a leading investment theorist like Meir Statman.But for each of these thoughtful people who are sympathetic to social investing, there are ten others who still think it is a dumb little sideshow.

July 19, 2008

Just a note to let you know that The Oxford Handbook of Corporate Social Responsibility is out. The book is a compilation of essays on corporate social responsibility from many different perspectives (I wrote the chapter on social investing). It's big - 656 pages, 2.6 pounds - so owning it is a sure sign of your commitment to the field!

It took a bit of hunting, but, finally, a decent obituary for Sir John Templeton, from The Economist.

Warren Buffett has the star power, but Templeton was arguably an equally skilled investor. Like Buffett, Templeton got his early training in securities analysis from Benjamin Graham.

When I was getting my MBA, my investments textbook listed four investors whose outstanding long-term track records were probably not due to chance: Warren Buffett, George Soros, Peter Lynch, and John Templeton.

Of that group, only Templeton had any use for social investors. He wrote in the late 80s that social investment funds "ought to be encouraged," and reportedly never owned a tobacco stock.

For those who believe one must behave dishonestly or unethically to achieve superior investment returns, the career Sir John Templeton stands as a provocative counter-example. For more information on Templeton in his prime, see John Train's excellent profile in The Money Masters.

May 06, 2008

UMass Amherst has just released its first Toxic 100 report since 2005. This is a pretty sophisticated analysis of air emissions, taking into account not just the volume of emissions, but also toxicity and how many people are impacted - even the direction of prevailing winds.

There is a reasonably thorough literature around stock price reactions to product recalls, but it seems to me to mostly miss the point. The real damage of a recall is likely to be reputational, so any impact on the stock price is going to occur over time. I think it would be better to try and focus on the long-term valuation effects.

Johnson & Johnson's response to the Tylenol incident (good briefing here) is regarded as the classic blueprint for how to handle a safety problem. But not all companies do so successfully. Perrier's leadership in the premium bottled water segment once seemed unassailable, until small amounts of benzene were found in the product, prompting the recall of 160 mm bottles. But in both cases the ultimate impact on firm value wasn't apparent until long after the fact.

I don't know if recalls can be studied quantitatively - the big ones are rare enough that it might be better to use the case study method. One thing that seems apparent is that each situation has its own logic. At a minimum the analyst needs to consider:

The direct economic impact of the recall (usually small)

How well the recall was handled

The completeness of the recall (is there still potentially dangerous product out there)

The potential for follow-on news (reports that the company hid problems, etc.)

The likely efficacy of the company's damage control measures

This is a probably a good example of something that can't be measured, but matters. I doubt we'll ever have an 'R' score that quantifies the impact of lost reputation of firm value. But analysts ignore reputational effects at their peril.

March 09, 2008

I've just finished Dan Ariely's Predictably Irrational, and recommend it to anyone who wants to learn more about behavioral economics. Ariely is a leader in challenging conventional economic wisdom, and provides empirical evidence of many situations where conventional economic analysis doesn't work well.

I was going to write in this post about the similarities and dissimilarities between this book and Freakonomics, which we've discussed here in the past. But, procrastination pays once again - Ariely yesterday wrote a note on this himself (read it here).

The books are similar in many ways, but taken together they frame a multi-disciplinary debate about how far economic analysis takes us. Behavioral economists are challenging some fundamental assumptions economists like to make about human behavior. It seems to me they are winning some and losing some, depending on the situation being analyzed - reading both of these books will give you a good sense of whose model might be better in a given situation.

February 18, 2008

This blog has been in suspended animation for awhile because I have been hard at work on another project: revamping sristudies.org.

I started sristudies.org in 1999, as a way to make available online citations and notes on the (then) small number of studies of socially responsible investing. Nine years on, the number of studies has grown exponentially, and I have to set aside more and more time each year to try and keep it reasonably up-to-date.

The job is already too hard for one person to do well, so I have begun to take the first steps to make sristudies.org a more collaborative project. The big changeover is now almost complete - I've moved the site to a wiki platform (hosted by the nice people at wikispaces.com), and updated most of the links so they refer to the new site. You can see the new site here. On the new platform I'll be able to give the database more consistent
attention, and, I hope, will be able to put some structure around a
database that now numbers several hundred studies.

I know, it doesn't look like much...we'll fix the graphics, it's on my list.

What I have done is update the new site with all the strong studies I saw in 2007. The simplest way to see these is to click the 'Bibliography' link and use your browser's search function to find all instances of '2007' on the page. Another way is to type '2007' in the search box.

I won't even attempt to summarize the class of '07 - the studies were uniformly thoughtful and challenging. You could start with Alex Edmans' Moskowitz Prize-winning piece, but I'd strongly recommend that you also have look at what Al Goss has been up to, and you should probably give Derwall's latest study a close look, too, and I don't know how to classify Christine Arena's book but you should look at it...and so on. A lot is happening, not just at the conferences and investment firms, but also among academic researchers around the world.

With the new platform, I hope it will be easier to keep up, and, ultimately, make this a collaborative effort. For now I'm leaving the old site up, but ultimately the sristudies.org web address will redirect to the wiki.